Variable Lease Payments – Types, Accounting Treatment, and Reporting under ASC 842 and IFRS 16

Variable lease payments are lease payments that change based on factors other than the passage of time. These payments can significantly affect the financial statements and must be carefully assessed under U.S. GAAP (ASC 842) and IFRS (IFRS 16) to determine whether they should be included in lease liabilities or expensed as incurred.

This article explains the types of variable lease payments, how they are treated by lessees and lessors, and when they are capitalized versus expensed.

1. What Are Variable Lease Payments?

Variable lease payments are any lease-related payments that vary based on external or usage-based conditions.

✦ Types of variable payments:

✦ Indexed to inflation (e.g., CPI adjustments)

✦ Based on usage or output (e.g., units produced, machine hours)

✦ Tied to performance or revenue (e.g., percentage of sales)

✦ Based on market rental rates

2. Lessee Accounting for Variable Lease Payments

Included in Lease Liability:

Under ASC 842 and IFRS 16, a variable payment is included in the initial lease liability only if it is:

✦ Based on an index or rate (e.g., CPI)

✦ Known at lease commencement or determinable from the contract

Example – CPI adjustment clause:

✦ Base rent = $10,000/month, adjusted annually for CPI

✦ Use initial CPI at commencement to calculate initial liability✦

Reassess only when lease payments are remeasured (e.g., lease modification)

Initial entry (lessee): Dr. ROU Asset – $480,000 / Cr. Lease Liability – $480,000.

Excluded from Lease Liability:

Payments based on performance or usage are not included in the lease liability.

✦ Instead, they are expensed as incurred in the period of use or achievement

Example – 3% of monthly sales: Dr. Lease Expense – $6,000 / Cr. Accounts Payable – $6,000.(If monthly sales = $200,000)

3. Lessor Accounting for Variable Lease Payments

Lessors exclude variable lease payments from the net investment in the lease (finance lease) or lease income (operating lease) unless they are fixed or indexed.

✦ Operating leases: variable payments are recognized as income in the period earned

✦ Finance leases: variable payments are recognized as income when received

Dr. Cash – $3,000 / Cr. Lease Income – $3,000.(Lessor receives usage-based rent)

4. Reassessment and Re-measurement

Lessees do not remeasure lease liabilities for changes in variable payments unless:

✦ A lease modification occurs

✦ A change in lease term or scope triggers remeasurement

✦ A contingency becomes fixed (e.g., performance target is achieved and rent increases)

Otherwise, changes in CPI or market rates are reflected prospectively, without adjusting past lease liability balances.

5. Disclosure Requirements

Entities must disclose:

✦ Nature and amount of variable lease payments not included in lease liabilities

✦ Conditions that trigger variable payments

✦ Lease expense or income related to variable components

✦ Significant judgments about whether variable payments are included in lease measurement

Disclosure example – lessee:“ Variable lease expenses of $75,000 were recognized during the year, primarily related to rent based on retail store revenue.”

Disclosure example – lessor:“ Variable lease income of $40,000 was earned from volume-based rental charges tied to the customer’s machine usage.”